Economic Recovery and Fiscal Balance

The economy remains fragile and is performing well below its potential. Despite this, Congress has little appetite for further action to support jobs and growth, and the deficit has become the fig leaf of choice for those wanting to stand in the way of additional supports.

But deficit reduction and job creation are not competing priorities. Job creation is needed today to ensure a strong economy and a solid tax base tomorrow: You can't reach reasonable budget targets without a strong and rapid recovery, and you won't get a strong recovery if you pursue austerity in a weak economy.

Without a variety of policy interventions, including the 2009 Recovery Act, the downturn would have been far worse. A recent, comprehensive report from economists Alan Blinder and Mark Zandi estimated that the unemployment rate would stand near 16 percent if it were not for anti-recession policies. However, although gross domestic product growth has turned positive, it has not been strong enough to generate adequate job creation.

Overall unemployment stood at 9.6 percent in August, after peaking at 10.1 percent in October 2009. The current unemployment rate is about the same as it was one year ago. The average length of unemployment has dramatically increased, and there are currently 6.2 million people who have been unemployed for more than six months. These people represent nearly half of the unemployed. There are currently about five unemployed workers for every job opening.

The economy currently has 7.7 million fewer jobs than it did at the start of the recession. The economy also needed to add about 3 million jobs in order to keep pace with population growth -- leaving a "jobs hole" of nearly 11 million jobs.

Economic forecasts show unemployment lingering at historically high levels. For example, Goldman Sachs forecasts unemployment to remain in the 9.5 percent to 10 percent range through the end of 2011. The Congressional Budget Office's most recent projections show unemployment averaging 8 percent in 2012 (more than four years after the beginning of the recession) and remaining above 6 percent through 2013. Clearly more work needs to be done, and the status quo remains unacceptable.

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Recessions have long-term consequences, and even "short term" recovery spending can have enormous long-term benefits. Public investment will boost growth in the short run and lead to greater economic capacity down the road.

A well-designed stimulus can have multiplier impacts on GDP, and some of the costs will be recouped through higher tax receipts. Zandi, who works at Moody's Analytics, estimates that every dollar spent on unemployment assistance generates $1.61 worth of economic activity, a dollar of spending on infrastructure yields $1.57, and a dollar in assistance to states to prevent layoffs of teachers or first responders yields $1.41. But this is just the short-term impact.

Over the long term, the U.S. economy must rest on a solid foundation that supports strong overall growth and rapidly rising incomes for all Americans -- not just those at the top. Public investments in infrastructure (including transportation, information, and water systems), in education from early childhood through higher education, and in innovation, health systems, and many other areas are key to providing this foundation. To sacrifice these investments in the name of deficit reduction would put the U.S. economy in a weaker position to address the long-term imbalances that will grow in the coming decades.

Even after the national economy more fully recovers, there will still be communities that will have substantially higher rates of unemployment. So broad-based investments should be complemented with targeted programs to ensure that no one is left behind.

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While deficits are manageable in the short run, there is a substantial problem over the long run. On the spending side, the main challenge is to restrain the cost growth in the health-care system. The recently passed health-care legislation helps, though more needs to be done. A single-payer system or public option would help reduce costs even more.

Although there is room to shrink spending on national defense, other discretionary spending has been shortchanged in recent decades and is too small to offer major budget savings. Even a complete elimination of all non-security discretionary spending would not lead to a sustainable budget.

This then leads us to the revenue side. Federal tax receipts as a proportion of GDP will rebound from the current 60-year low as profits and incomes recover, but additional revenue is needed both to close the deficit and to support national priorities.

In 2020, if the Bush tax changes are extended, the deficit would reach 5.1 percent of GDP, or about $1.23 trillion. Getting this down to sustainable levels -- about 3 percent of GDP, would thus require spending cuts or revenue increases of about $500 billion in that year. Under President Barack Obama's budget, which rolls back some of the tax cuts for the top, deficits would reach only 3.8 percent of GDP in 2020, leaving a much smaller gap to close.

Bush Tax Cuts. Reversing the cuts in the top tax brackets would generate significant revenue from those who have seen the biggest gains in their income over the past three decades. President Obama has proposed repealing the reductions for those making more than $250,000. That would yield some $629 billion over the next 10 years, some of which could fund supports for those hardest hit by the recession, aid state and local governments, fund transportation projects, and even help localities directly employ some of the 14.9 million people who are ready to work, while also reducing the deficit in the long run. The cost of extending the upper-income Bush tax cuts, in both dollars and lost opportunities, is unacceptably high.

Tax Expenditures. Tax deductions and preferences represent about $1 trillion in lost revenue annually. Under the current system, those in higher tax brackets get larger reductions, so the net effect of these preferences makes the tax system less progressive, according to a 2008 Urban Institute study. The president has proposed limiting the value of deductions to 28 percent, though one could go lower and preserve current incentives for most taxpayers. Scrubbing the code to remove or limit ineffective provisions would also yield significant revenue.

Capital Gains and Dividends. The Bush tax changes reduced the rate on capital gains for top earners from 20 percent to 15 percent and reduced dividend tax rates from 39.6 percent to 15 percent. The president has proposed raising these rates to 20 percent for those making over $250,000, but there is a strong case for treating income from capital the same as income from work. As billionaire investor Warren Buffett has noted, he pays a lower federal tax rate than does his secretary because he receives his income as capital gains. The top 20 percent of households would bear 98.4 percent of the incidence of this tax increase.

Corporate Taxes. The top marginal rate for most corporations is 35 percent, higher than most other developed countries; however, most corporations pay less due to myriad exemptions, deductions, and credits -- the "effective" tax rate is significantly less. In fact, in 2007 the U.S. collected just 2.7 percent of GDP in corporate revenue, compared with an average rate for nations that are members of the Organization for Economic Cooperation and Development of 3.7 percent. Some suggest eliminating these preferences in exchange for a lower tax rate (which is much like stopping your accountant's embezzling but rewarding him with a higher fee). But 100 percent of the revenue gains from limiting tax preferences need not go toward lower rates. Asking corporations to pay a bit more would not lead to massive offshoring and would ease the adjustments that need to be made elsewhere.

Payroll Taxes. Social Security payroll taxes are currently imposed on up to $106,800 of an employee's earnings, and this maximum is adjusted for wage growth annually. Income above the cap is not taxed. There is no comparable maximum earnings threshold for Medicare payroll taxes. As of 2009, as a result of growing income inequality, approximately 83 percent of taxable earnings fell below the cap -- down from roughly 91 percent in 1983. Restoring the 90 percent threshold or eliminating the cap altogether would raise significant revenue for the program.

Add to this list the usual suspects of tax enforcement, corporate loophole closures, offshore tax evasion, a responsible fix to the alternative minimum tax, and a fair estate tax. Proposals to create a "millionaire surcharge" have also received support in Congress as part of the health-care debate.

Other sources of revenue, if done right, could also contribute to the revenue pool. A carbon tax or cap-and-trade system, if coupled with support for low- and moderate-income consumers, could generate significant revenue and lessen the burden of the income-tax code. There would of course be the added benefit of, say, a livable earth.

A value-added tax (VAT) -- which is like a broad-based sales tax -- is another source of revenue that could be added to the current code. The U.S. is somewhat unique among other advanced economies, most of which use a VAT as a complement to their other tax sources. Given the inherently regressive nature of a VAT (lower-income consumers spend a greater share of their income than do those at the top), other changes to the tax would have to be made to ensure overall fairness. It also makes sense to fix the current code before adding another revenue stream.

This menu of changes is not radical. The options are not outside the historical experience of the U.S. or of other developed countries. They place the revenue responsibility more squarely on those with the fastest income growth.